Secondly, monetary policy among the world’s major central banks is now entering a period of divergence. After years in which globally coordinated monetary easing suppressed volatility, asset markets have much less capacity to absorb any reverberations caused by a policy split. Volatile swings in sentiment will almost surely make a swift comeback. This is good news for tactical asset allocators who rely on shifting psychology to generate alpha.
Policy divergence will also create winners and losers in global currencies. In the past, when European and U.S. monetary policies moved in different directions, markets have adjusted significantly.
In those instances, the European Central Bank (or the Bundesbank) was tightening while the Fed was easing, increasing risks for the dollar. Roles are reversed this time. As long as divergence continues, the dollar will remain chronically strong versus countries that continue pursuing QE. In these cases, investors should use ETFs that hedge those domestic currencies back to the dollar.
Thirdly, investors need to anticipate likely central bank exit scenarios for reducing QE-bloated balance sheets. The Fed’s balance sheet has expanded from 6.5 percent of U.S. gross domestic product in 2008 to about 25 percent today. If this fourfold expansion were reversed by 2020, the Fed would become a larger seller of bonds than the U.S. government.
Clearly that will not happen. In fact, balance-sheet contraction anytime soon is also unlikely. After the Fed’s drive in recent years to extend the duration of its balance sheet (remember “Operation Twist”?), almost none of those assets will mature in the coming year—only $2 billion of its $2.4 trillion in Treasurys will expire in the next 12 months.
The most likely path then is for the Fed to maintain its massive balance sheet and slowly reduce it as maturity dates are hit.
Still, no change is a big change. While the Fed’s balance sheet will be stable, its significance as a marginal buyer will also fade and more bonds will be purchased by price-sensitive investors. Perhaps “fundamentals” rather than just liquidity will finally count for something again!
A Prescription For Feeling Fine
When REM first played its hit single live, the audience reacted with a vibe that caught the band by surprise. Band members were convinced the apocalyptic lyrics would create a more subdued response, but instead the audience was energized.
Similarly, some have expected that anticipation of the end of QE3 would have had more sobering effects on the market. Remarkably, it has not generated market instability. Rather, for the most part, the appetite for “risk” assets that QE engendered has continued.
However, more often than not, policymaker attempts to cushion volatility of the economic cycle ends up increasing volatility of financial markets down the road. That does not necessarily mean markets will weaken after the Fed’s retreat from an unprecedented policy-easing experiment, but that a realignment of asset values and market leadership will get underway.
Tactical asset allocators should remain alert and have their playbooks ready.
Tyler Mordy, president and co-chief investment officer of Hahn Investment Stewards, is an expert in the design and application of global macro ETF managed portfolios. He is interviewed by the financial media for his global investment strategy views, as well as ETF trends. CNBC has called him one of the “best independent ETF experts.” Contact Hahn at hahninvest.com/contact.